The perils of reaching the truth before Krugman

Once Paul Krugman has reaching a firmly held policy view, it can be costly to express a contrary opinion.  Just ask Ken Rogoff or Tyler Cowen.  On the other hand he can be very supportive to those who toe the party line:

Joe Gagnon Is Right

He calls on the Fed to implement a plan based on the ideas of someone the central bank seems to have been ignoring “” a macroeconomist by the name of Ben Bernanke.

Of course Krugman has recently been calling on the Fed to ease monetary policy, having basically given up on Congress providing more fiscal stimulus.  Gagnon called for eliminating the interest rate on reserves, and suggested that the Fed buy Treasury bonds.  There was no mention of Krugman’s favorite idea, higher inflation targets.

But what happens if you call for monetary stimulus before Krugman is ready, while he is still pinning his hopes on fiscal stimulus?  On March 1, 2009, I wrote an open letter to Krugman calling for a three-pronged attack on deflation; elimination of IOR, having the Fed buy Treasury bonds, and Krugman’s favorite idea, inflation targeting.  So he must have liked my proposal even more that Gagnon’s, right?   Ummm . . .  actually not:

A quick response to Scott Sumner OK, I see that Scott Sumner has written an open letter to me. But I’m puzzled. He writes:

“I think you have acknowledged that there is some level of quantitative easing that would boost demand. If I am not mistaken you are concerned that if such a policy boosted inflation expectations sharply, the Fed would have to quickly sell off these assets, suffering massive capital losses.”

Um, you are mistaken. I’ve never said such a thing. Did you mean to address this letter to someone else?

Very funny.  Why the negative reaction?  Here was my concluding paragraph:

To conclude, I ask you to reconsider your position on monetary policy.  If you did change your view, some people might accuse you of inconsistency. But remember what your hero once said:

“When the facts change, I change my mind “” what
do you do, sir?”

The Obama administration is obviously struggling in coming up with an effective solution to the banking crisis.  The stimulus package seems inadequate, either because (as you believe) it is too small, or (as I believe) the multiplier may be less than we think.  The economic data seems to be consistently worse than expected.  The facts have changed.

In early March, 2009, Krugman wasn’t ready to hear this message, especially from a right wing economist.   Now he is.

Part 2.  The Fedfail index

I suppose I should include something a bit less petty and self-indulgent in this post, so let’s consider Krugman’s Fedfail index:

But forecasts aside, we really have to bear in mind that the Fed is failing in fulfilling its dual mandate, price stability and full employment. I thought it might be convenient to have a simple measure of just how big the failure is; let’s call it the Fedfail Index. It’s related to the Taylor rule, but instead of offering a rule of thumb for the Fed funds rate, it measures how far unemployment and inflation are from their presumed targets.

The rule I’ve chosen takes its coefficients from the Rudebusch version of the Taylor rule; 1.3 times the deviation of unemployment from 5 percent + 2 times the deviation of core inflation (CPI) from 2 percent. So it’s 1.3* ABS(unemployment – 5) + 2* ABS(core inflation – 2). You can make up your own version; I don’t think it will look very different.

I don’t have any big problem with this index, but I prefer to use NGDP deviations from trend for two reasons.  First, I’d rather not try to estimate the natural rate of unemployment.  So I prefer NGDP (which includes real output) rather than unemployment.  Of course the closest parallel would be to use deviations from the natural rate of real output, which is equally hard to estimate.  But I favor simply targeting NGDP, as most of the problems (wrongly) attributed to inflation instability are actually associated with instability in NGDP growth.

More importantly, my Fedfail index treats supply shocks very differently from Krugman’s index.  In Krugman’s index each term is calculated as an absolute value.  Thus if a supply shock causes both unemployment and inflation to rise above normal, the Fedfail index gets worse.  But in my view that’s not really a monetary policy failure, as the Fed can’t do much about supply shocks.  So I’d prefer to use a steady 5% NGDP growth track as my benchmark for success, even if a supply shock causes inflation to rise above 2% and real growth to fall below 3%.  In a sense, Krugman’s index shows how poorly the economy is doing, not how much AD is deviating from its appropriate level.

[Note, please let me know if I misinterpreted Krugman’s index, especially the absolute value expression.]

PS.  The snarky “party line” comment wasn’t aimed at Gagnon, he’s been saying these things for a long time—indeed arguably helped created the “party line.”  Instead, it was aimed at Krugman.  And a note to Krugman-lovers:  I hope it goes without saying that the whole thing was meant to be humorous, I am quite aware that Krugman has held some of these views for quite a long time, it’s just that recently he is giving them more emphasis.



7 Responses to “The perils of reaching the truth before Krugman”

  1. Gravatar of Indy Indy
    24. July 2010 at 10:59

    Here’s my problem with Krugman’s index: If we had 100% employment with 0 inflation – would that be “Fed Fail” or “Fed Success”? It would get a hefty 10.5 on his fail index. 5% higher unemployment and 2% higher inflation get a “perfect” 0. 10% unemployment with 4% inflation gets us back to 10.5. But the first set of conditions would be great, while the second set would be awful.

    Krugman would respond by saying “Oh, but those first conditions are impossible according to my Macroeconomic model. The Fed could never achieve that. I’m trying to measure the difference between what the fed could actually do, and what they are presently achieving.”

    But it doesn’t look like the index measures that, and then there’s some debate about what the fed could actually accomplish in the short run. Let’s say the Fed ramps up inflation, say, to 5%. It would gradually drive down unemployment, but not overnight. The index would look like they were failing *even worse*, but they would be succeeding if that policy eventually brought down unemployment.

    So, it seems to just be a measure of how bad the economy is and not a particularly good one.

  2. Gravatar of JTapp JTapp
    24. July 2010 at 16:54

    Did you catch this sentence by Krugman today?
    “So it’s not safe to assume that the Fed can, for example, hit any target for nominal GDP that it chooses.”

  3. Gravatar of StatsGuy StatsGuy
    24. July 2010 at 16:55

    (Post got lost, so if it shows and this is a dup, sorry)

    First, the FedFail index is brilliant marketing – it’s the counterpoint to the Misery Index, and it really sticks it to the Fed in pointing out just how much they are failing at their mission. Marketing is important.

  4. Gravatar of scott sumner scott sumner
    24. July 2010 at 17:19

    Indy, That’s the mirror image of the problem I identified. I spoke of a negative supply shock, you highlighted the case of a very positive productivity shock. It doesn’t handle non-monetary shocks very well.

    JTapp, Yeah, and he posted that about the same time I did. I sort of wondered whether he was responding to me, or perhaps David Beckworth, who also posts a lot on NGDP, and who Krugman has commented on before. I might do a short post.

    Statsguy, Nobody can question Krugman’s skill as a blogger, he is very talented. But what about the supply shock issue, should monetary policymakers be blamed for stagflation?

  5. Gravatar of Doc Merlin Doc Merlin
    24. July 2010 at 19:23

    ‘Statsguy, Nobody can question Krugman’s skill as a blogger, he is very talented. But what about the supply shock issue, should monetary policymakers be blamed for stagflation?’

    The Keynesian tend to ignore the supply side, much like the original classicals ignored the demand side a bit.

  6. Gravatar of StatsGuy StatsGuy
    24. July 2010 at 19:56

    Unfortunately, I can’t seem to post the second part of my comment, so hopefully this gets through.

    Krugman may not listen to you, but Gagnon has been listening for quite some time.

    Since I cannot post the link without hitting some sort of filter, I suggest you look at his guest post on Nov 9 2009 at Econbrowser.

  7. Gravatar of ssumner ssumner
    25. July 2010 at 18:39

    Doc Merlin, That’s right.

    Statsguy, Yes I saw that. I conversed with Gagnon last year by email. I can’t be certain, but I think he might have moved a bit my way on the interest on reserves question. He seemed a bit skeptical when I brought it up earlier, but did mention it in his recent article. This is based on memory, but it did not seem to be mentioned in the November 2009 post, FWIW.

Leave a Reply